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Derivatives Users Likely to See Higher Costs

Rising OTC costs may push companies to clear derivatives.

Nearly 60% of global financial institutions say higher capital requirements will make them wary about engaging in capital-intensive businesses, such as derivatives transactions, and 18% say they will pass the associated costs on to clients, according to a recent survey. In fact, the survey, conducted by SunGard and the Professional Risk Managers’ International Association (PRMIA), found a quarter of respondents have already exited such businesses.

While the survey collected input mostly from financial institutions, its results point to rising costs and fewer providers, which almost certainly means higher prices for corporate users of derivatives.

A separate survey, conducted by Reval, a provider of treasury and risk management software, found 34% of corporate respondents expect new regulations will either increase their costs or reduce the extent of their hedging activities.

The SunGard/PRMIA also found that 43% of sell-side participants and 84% of buy-side institutions, including some large corporates, expect that less than half their derivatives contracts will be cleared by the end of 2013. And it highlights another issue likely to weigh on companies that use derivatives: It finds most financial institutions have yet to implement comprehensive systems to calculate credit value adjustments (CVAs).

Financial Accounting Standard 157 and International Accounting Standard 39 require both financial and nonfinancial companies to apply CVAs when appropriate. CVAs occur when an institution enters a bilateral derivative transaction with a counterparty of weaker credit standing. The fair value of the derivative is marked down to adjust for the increased risk of the counterparty defaulting.

“If a company has to do a profit and loss adjustment for all its derivative transactions, that can be significant,” says Dan Travers, a product manager for Adaptiv Analytics, SunGard’s pricing and simulation engine.

Since the financial crisis, auditors have pushed companies to calculate CVAs more accurately, Travers says.

Krishnan Iyengar, vice president of global solutions at Reval, a provider of treasury and risk management software solutions, agrees there has been pressure to employ more sophisticated CVA calculations, especially since the collapse of big derivative counterparties such as Lehman Brothers. Larger banks have adopted highly sophisticated Monte Carlo simulations to calculate CVAs, says Iyengar, who's pictured above, while nonfinancial companies tend to use less sophisticated methods, such as incorporating credit-default-swap spreads into their valuation models.

Tom Deas, treasurer at FMC Corp and chairman of the National Association of Corporate Treasurers (NACT), says the issue of CVAs has not gotten much attention among NACT members. That’s because most of NACT’s member companies are investment grade, similar to their bank counterparties, reducing the impact of CVAs, says Deas, pictured at left.

Calculating CVAs becomes more critical when companies are rated less than investment-grade, resulting in a greater credit spread between them and their bank counterparties. If the vast majority of swaps remain uncleared, as the SunGard survey suggests, and auditors continue to push for CVAs, non-investment-grade companies could find themselves incurring costs to implement more sophisticated CVA calculation systems.

Perhaps more importantly, CVAs impact banks’ P&Ls as well as their capital adequacy. As higher capital requirements kick in, CVAs could become ever more critical.

“If banks’ reserves are bigger because of the CVA, then that’s diverting capital away from lending and the economy overall, and requiring it to be used for what essentially is a regulatory tax,” Deas says.

Ultimately, higher costs for uncleared derivative trades could push more corporate end users to clear their transactions, eventually removing the CVA issue. Iyengar notes that Dodd-Frank pushes derivative users toward swap execution facilities and clearing, or toward establishing collateral agreements with their banks, either of which eliminate higher capital charges for the banks.

Iyengar acknowledges that corporates tend to favor the economic benefits and customization of bilateral transactions with financial institutions, but he says the interplay of Dodd-Frank and Basel III appear set to make those advantages go away.

“It’ll become, who do you want to post margin to, your central clearing party or your bank?” he says. “And if you still want a bilateral transaction, your costs will go up.”

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